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MICROECONOMICSFIFTH EDITION

DAVID A. BESANKONorthwestern University,Kellogg School of Management

RONALD R. BRAEUTIGAMNorthwestern University,Department of Economics

with Contributions from

Michael J. GibbsThe University of Chicago,Booth School of Business

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To our wives . . .Maureen and Jan

. . . and to our childrenSuvarna and Eric, Justin, and Julie

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DAVID BESANKO is the Alvin J. Huss Distinguished Professor of Management andStrategy at the Kellogg School of Management at Northwestern University. From 2007 to 2009he served as Senior Associate Dean for Academic Affairs: Strategy and Planning and from 2001to 2003 served as Senior Associate Dean for Academic Affairs: Curriculum and Teaching.Professor Besanko received his AB in Political Science from Ohio University in 1977, his MSin Managerial Economics and Decision Sciences from Northwestern University in 1980, andhis PhD in Managerial Economics and Decision Sciences from Northwestern University in1982. Before joining the Kellogg faculty in 1991, Professor Besanko was a member of the fac-ulty of the School of Business at Indiana University from 1982 to 1991. In addition, in 1985, heheld a postdoctorate position on the Economics Staff at Bell Communications Research.Professor Besanko teaches courses in the fields of Management and Strategy, CompetitiveStrategy, and Managerial Economics. In 1995 and 2010, the graduating classes at Kelloggnamed Professor Besanko the L.G. Lavengood Professor of the Year, the highest teachinghonor a faculty member at Kellogg can receive. He is only one of two faculty members ofKellogg to have received this award twice. At the Kellogg School, he has also received theAlumni Choice Teaching Award in 2006, the Sidney J. Levy Teaching Award (1998, 2000, 2009,2011) the Chairs Core Teaching Award (1999, 2001, 2003, 2005), and Certificate of Impactawards from students (2009, 2010, 2011, 2012, 2013).

Professor Besanko does research on topics relating to competitive strategy, industrial or-ganization, the theory of the firm, and economics of regulation. He has published two booksand over 40 articles in leading professional journals in economics and business, including theAmerican Economic Review, Econometrica, the Quarterly Journal of Economics, the RAND Journal ofEconomics, the Review of Economic Studies, and Management Science. Professor Besanko is aco-author of Economics of Strategy with David Dranove, Mark Shanley, and Scott Schaefer.

RONALD R. BRAEUTIGAM is the Harvey Kapnick Professor of Business Institutionsin the Department of Economics at Northwestern University. He is currently Associate Provostfor Undergraduate Education, and he has served as Associate Dean for Undergraduate Studiesin the Weinberg College of Arts and Sciences. He received a BS in Petroleum Engineering fromthe University of Tulsa in 1970 and then attended Stanford University, where he received an MSin engineering and a PhD in Economics in 1976. He has taught at Stanford University and theCalifornia Institute of Technology, and he has also held an appointment as a Senior ResearchFellow at the Wissenschaftszentrum Berlin (Science Center Berlin). He also has worked in bothgovernment and industry, beginning his career as a petroleum engineer with Standard Oil ofIndiana. He served as research economist in The White House Office of TelecommunicationsPolicy and as an economic consultant to Congress, many government agencies, and private firmson matters of pricing, costing, managerial strategy, antitrust, and regulation.

Professor Braeutigam has received many teaching awards, including the NorthwesternUniversity Alumni Association Excellence in Teaching Award (1991), and recognition as aCharles Deering McCormick Professor of Teaching Excellence at Northwestern (19972000),the highest teaching award that can be received by a faculty member at Northwestern.

Professor Braeutigams research interests are in the field of microeconomics and industrialorganization. Much of his work has focused on the economics of regulation and regulatory reform, particularly in the telephone, transportation, and energy sectors. He has publishedmany articles in leading professional journals in economics, including the American EconomicReview, the RAND Journal of Economics, the Review of Economics and Statistics, and theInternational Economic Review. Professor Braeutigam is a co-author of The Regulation Game withBruce Owen, and Price Level Regulation for Diversified Public Utilities with Jordan J. Hillman. Healso has served as President of the European Association for Research in Industrial Economics.

iii

A B O U T T H E A U T H O R S

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iv ABOUT THE AUTHORS

MICHAEL GIBBS is Clinical Professor of Economics, and Faculty Director of theExecutive MBA Program, at the University of Chicago Booth School of Business. He also is aResearch Fellow of the Institute for the Study of Labor, and the Institute for CompensationStudies. Professor Gibbs earned his AB, AM, and PhD in Economics from the University ofChicago. He also has taught at Harvard, the University of Michigan, USC, Sciences Po (Paris),and the Aarhus School of Business (Denmark). Professor Gibbs has won several teaching and re-search awards. He is a leading scholar in personnel economics, publishing in journals such as theQuarterly Journal of Economics, Accounting Review, and Industrial & Labor Relations Review. His research focuses on organizational design, incentives, and the economics of personnel policies.He is co-author of the textbook Personnel Economics in Practice, with Edward Lazear. ProfessorGibbs is a Director at Cummins Western Canada and Huy Vietnam, and advisor to several startups.

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vAfter many years of experience teaching microeconomics at the undergraduate and MBAlevels, we have concluded that the most effective way to teach it is to present the contentwith a variety of engaging applications, coupled with an ample number of practice problems and exercises. The applications ground the theory in the real world, and the exercises and problems sets enable students to master the tools of economic analysis andmake them their own. The applications and the problems are combined with verbal intu-ition and graphs, so that they are reinforced and amplified.This approach enables studentsto see clearly the interplay of key concepts, to thoroughly grasp these concepts throughabundant practice, and to see how they apply in actual markets and business firms.

Our reviewers and adopters of the first edition told us that this approach workedfor them and their students. In the second edition, we built on this approach, addingeven more applications and problems and revisiting every explanation, every graph, andevery Learning-By-Doing exercise to make sure the text was as clear as possible. In thethird edition, we continued in the spirit of the second edition, adding more current ap-plications and problems. In fact, we added at least five problems to each chapter (nearly90 new problems in all). In the fourth edition, we added still more new problems, andwe introduced over 30 new applications. In addition, we added a new Appendix toChapter 4 that introduces the basic concepts of time value of money, such as presentand future value. Finally, every chapter now begins with a set of concrete, actionablelearning goals based on Blooms Taxonomy of Educational Objectives. In the fifth edi-tion, we updated applications and chapter openers, and added new applicationsthroughout the book, many with a focus on current events. Each major section of everychapter now has at least one application. We also added new material to Chapter 15 onpay for performance and to Chapter 17 on contrasting emissions fees, emissions stan-dards, and tradable permits.

The Solution Is in the Problems. Our emphasis on practice exercises and numer-ous, varied problems sets this book apart from others. Based on our experience, studentsneed drills in order to internalize microeconomic theory. They need to work throughmany problems that are tangible, problems that have specific equations and numbers inthem. Anyone who has mastered a skill or a sport, whether it be piano, ballet, or golf, un-derstands that a fundamental part of the learning process involves repetitive drills thatseemingly bear no relation tohow one would actually executethe skill under real conditions.We feel that drill problems in mi-croeconomics serve the samepurpose. A student may neverhave to do a numerical compara-tive statics analysis after complet-ing the microeconomics course.However, having seen concretely,through the use of numbers andequations, how a shift in demandor supply affects the equilibrium,a student will have a deeper

P R E F A C E

Problem

(a) Suppose a constant elasticity demand curve is givenby the formula . What is the price elasticityof demand?

(b) Suppose a linear demand curve is given by the formula . What is the price elasticity ofdemand at P 30? At P 10?

Solution

(a) Since this is a constant elasticity demand curve, theprice elasticity of demand is equal to everywherealong the demand curve.

(b) For this linear demand curve, we can find the priceelasticity of demand by using equation (2.4):

12

Q 400 10P

Q 200P12

Elasticities along Special Demand Curves

. Since b 10 and Q 400 10P,when P 30,

and when P 10,

Note that demand is elastic at P 30, but it is inelastic atP 10 (in other words, P 30 is in the elastic region ofthe demand curve, while P 10 is in the inelastic region).

Similar Problems: 2.5, 2.6, 2.12

Q, P 10 a 10400 10(10)b 0.33

Q,P 10 a 30400 10(30)b 3

Q, P (b)(PQ)

L E A R N I N G - B Y- D O I N G E X E R C I S E 2 . 6

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vi PREFACE

appreciation for comparative statics analysis and will be better prepared to interpret eventsin real markets.

Learning-By-Doing exercises, embedded in the text of each chapter, guide the stu-dent through specific numerical problems. We use three to ten Learning-By-Doingexercises in each chapter and have designed them to illustrate the core ideas of the chap-ter. They are integrated with the graphical and verbal exposition, so that students canclearly see, through the use of numbers and tangible algebraic relationships, what thegraphs and words are striving to teach. These exercises set the student up to do similarpractice problems as well as more difficult analytical problems at the end of each chapter.

As noted above, we have added to the already complete end-of-chapter problem setsto give students and instructors more opportunity to assess student understanding.Chapters have between 20 and 35 end-of-chapter exercises. There is at least one exer-cise for each of the topics covered in the chapter, and the topics covered by the exer-cises generally follow the order of topics in the chapter. At the end of the book, thereare fully worked-out solutions to selected exercises.

It Works in Theory, but Does It Work in the Real World? Numerous real-world examples illustrate how microeconomics applies to business decision makingand public policy issues. We begin each chapter with an extended example that intro-duces the key themes of the chapter and uses real markets and companies to reinforce

particular concepts and tools.Each chapter contains, on av-erage, seven examples, calledApplications, woven into thenarrative or highlighted insidebars. In this fifth edition,we have taken care to updateour applications and to add tothem, so that we now haveover 120 Applications. A fulllist may be found on the frontendpapers of this text. New

applications includehealth care reform in theU.S., federal income taxreform, parking meterprivatization in Chicago,and the bailout of theParmesan cheese indus-try in Italy.

Graphs Tell theStory. We use graphsand tables more abun-dantly than most texts,because they are centralto economic analysis, en-abling us to depict com-plex interactions simply.

prices usually rise in the spring through late sum-mer, due to warmer weather, closed schools, andsummer vacations. They are usually lower in winter.Gasoline prices can also fluctuate due to changes in crude oil prices, since gasoline is refined fromcrude oil.

In addition to these factors, gasoline prices arehighly responsive to changes in supply. Prices maychange dramatically if there are disruptions to the supply chain. Typical inventory levels of commer-cial gasoline usually amount to only a few days of

Gasoline prices tend to be highly volatile. Figure 2.24illustrates this by plotting the average retail gasolineprice in the United States in 2005.23 Large swings inprice in short periods of time are common, as areseasonal fluctuations. The seasonal changes arelargely attributable to shifts in demand. Gasoline

A P P L I C A T I O N 2.8

What Hurricane Katrina Tells UsAbout the Price Elasticity of Demandfor Gasoline

Quantity (billions of bushels per year)

Pric

e (do

llars

per b

ush

el)

13 14118 9

$5

$3

Excess supplywhen price

is $5

$4E

S

D

Excess demand

when price is $3FIGURE 2.5 Excess Demand and ExcessSupply in Market for CornIf the price of corn were $3, per bushel, excessdemand would result because 14 billion bushelswould be demanded, but only 9 billion bushelswould be supplied. If the price of corn were $5per bushel, excess supply would result because13 billion bushels would be supplied but only 8 billion bushels would be demanded.

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PREFACE vii

In economics, a picture truly is worth a thousand words. In each new edition we haveworked to make the graphs even clearer and more useful for students.

Get to the Point. All too often, verbal explanations of economic ideas and con-cepts seem convoluted and unintuitive. Tables and graphs are powerful economictools, but many students cannot interpret them readily at first. We believe our expo-sition of the economic intuition underlying the graphs is clear and easy to follow. Wehave worked through every line to streamline the exposition. Patient step-by-step explanations with examples enable even nonvisual learners to understand how graphsare constructed and what they mean.

ORGANIZATION AND COVERAGEThis book is traditional in its coverage and organization. To the extent that we have madea trade-off, it is to cover traditional topics more thoroughly, as opposed to adding a broadrange of additional topics that might not easily fit into a one-quarter or one-semester microeconomics course. Thus an instructor teaching a one-semester microeconomicscourse could use all or nearly all of the chapters in the book, and an instructor teachinga one-quarter microeconomics or managerial economics course could use more thantwo-thirds of the chapters. The following chart shows how the book is organized.

ImperfectlyPerfectly Competitive

Introduction to Consumer Production and Competitive Monopoly and Markets andMicroeconomics Theory Cost Theory Markets Monopsony Strategic Behavior Special Topics

1 3 6 9 11 13 15

Overview and Introduction Production Profit-maximizing Theories of Price determina- Risk,uncertainty,introduction to consumer function, output choice by a monopoly and tion in imperfectly and information,to constrained choice marginal price-taking firm monopsony competitive including aoptimization, and average and prices in short- price setting markets utility-theoreticequilibrium product, and run and long-run approach to analysis, and returns equilibrium uncertainty and comparative to scale decision treestatics analysis analysis, Insurance

markets andasymmatric infor-mation, and auctions

2 4 7 10 12 14 16

Introduction Budget lines, Concept of Using the Price discrimi- Simultaneous- Overview ofto demand utility maxi- cost, input competitive nation move games general equi-curves, supply mization, and choice and market model and sequential- librium theorycurves, market analysis of cost to analyze move games and economicequilibrium, revealed minimization public policy efficiencyand elasticity preference interventions

5 8 17

Comparative Construction Externalitiesstatics of of total, and publicconsumer average, and goodschoice and marginal costconsumer curvessurplus

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viii PREFACE

ALTERNATIVE COURSE DESIGNSIn writing this book, we have tried to serve the needs of instructors teaching micro-economics in a variety of different formats and time frames.

One-quarter course (10 weeks): An instructor teaching a one-quarter un-dergraduate microeconomics course that fully covers all of the traditionaltopics (including consumer theory and production and cost theory) wouldprobably assign Chapters 111. If the instructor prefers to deemphasize con-sumer theory or production theory, he or she might also be able to coverChapters 13 and 14.

One-semester course (15 weeks): In a one-semester undergraduate course, aninstructor should be able to cover Chapters 115. If the course must includegeneral equilibrium theory, public goods, and externalities, then Chapter 15could be dropped and the instructor could assign Chapters 114, 16, and 17.

Two-quarter course (20 weeks): For a two-quarter sequence (the structure we have at Northwestern), the first quarter could cover Chapters 111, and the second quarter could pick up where the first quarter left off and coverChapters 1217.

MBA-level managerial economics course (10 weeks or 15 weeks): For aone-quarter course, the instructor would probably want to skip the chapters onconsumer theory, production functions, and cost minimization (Chapters 36and the second half of Chapter 7) and cover Chapters 12, the first half ofChapter 7economic concepts of costChapter 8, and Chapters 914.Extending such a course to a full semester would allow the instructor to includethe material on production and cost minimization as well as Chapter 15.

TEACHING AND LEARNING RESOURCESCOMPANION WEBSITE (www.wiley.com/college/besanko) includes resources forboth students and instructors. Provides many of the resources listed here as well asLecture Outline PowerPoint presentations, and Excel-based problems that providegraphical illustrations related to key concepts within the text.

INSTRUCTORS MANUAL includes additional examples related to the chapter topics, references to relevant written works, website addresses, and so on, which enhance the material within each chapter of the text, additional problem sets, andsample exams.

SOLUTIONS MANUAL provides answers to end-of-chapter material and worked outsolutions to any additional material not already provided within the text.

TEST BANK contains nearly 1,000 multiple-choice and short answer questions as wellas a set of problems varying in level of difficulty and correlated to all learning objectives.

COMPUTERIZED TEST BANK consists of content from the Test Bank providedwithin a test-generating program that allows instructors to customize their exams.

STUDENT PRACTICE QUIZZES contain at least 1015 practice questions per chapter.Multiple choice and short answer questions, of varying difficulty, help students evalu-ate individual progress through a chapter.

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PREFACE ix

The Wiley E-Text: Powered by VitalSource gives students anytime, anywhere, accessto the best economics content when and where they study: on their desktop, laptop,tablet, or smartphone. Students can search across content, highlight, and take notes thatthey can share with teachers and classmates.

Wileys E-Text for Microeconomics, Fifth Edition takes learning from traditional tocutting edge by integrating inline interactive multimedia with market-leading content.This exciting new learning model brings textbook pages to lifeno longer just a statice-book, the E-Text enriches the study experience with dynamic features:

Clickable Images enlarge so students can view details up close Interactive Tables and Graphs allow students to access additional rich layers

of explanation by manipulating slider controls or clicking on embeddedhotspots incorporated into select tables and graphs

Embedded Practice Quizzes appear inline and are contextual within theE-Text experiencestudents practice as they read and receive instant feedbackon their progress

Audio-Enhanced Graphics provide further explanation for key graphs in theform of short audio clips

STUDY GUIDE includes a Chapter Summary, Exercises with Answers, ChapterReview Questions with Answers, Problems with Answers, and Practice ExamQuestions with Answers for each chapter.

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While the book was in development, we benefited enormously from the guidance ofa host of individuals both from within John Wiley & Sons and outside. We appreciatethe vision and guidance of the economics team at Wiley. Their commitment to thisbook has remained strong from the beginning of the first edition. We are grateful fortheir support.

We would like to thank Joel Hollenbeck, Executive Editor, for guiding, encour-aging, and supporting us throughout this fifth edition. Jennifer Manias, ProjectEditor, provided editorial support and kept us on track with deadlines on this andprevious editions. Amy Scholz and Puja Katariwala, in marketing, worked tirelesslyto reach our markets. Others at Wiley who contributed to the beautiful productionand design include Dorothy Sinclair, Sandra Dumas, Maddy Lesure, and KathleenPepper.

We are extraordinarily grateful to Michael Gibbs, who made significant contribu-tions to the Applications in the fourth and fifth editions. He updated existingApplications and added many new Applications. In so doing, he has helped us keep thebook fresh and up to date. Mikes work was creative, thoughtful, well-organized, andconscientious. It is a pleasure to work with him.

The clarity of the presentation and organization in this book owes a great dealto the efforts of Leonard Neufeld, who provided a close and insightful line and artedit. Len carefully worked through every line of the manuscript and made numerousthoughtful suggestions for sharpening and streamlining the exposition. MelissaHayes, at the time a Northwestern undergraduate, made extensive suggestions formaking the first edition of the book readable from a students point of view. We owea special debt to Nick Kreisle. Nick has worked with us as a colleague, as a teachingassistant in our courses, and as an instructor using our text in his own course in in-termediate microeconomics. He carefully reviewed drafts of the manuscripts of thefirst and second editions, and provided many valuable suggestions. We are pleasedthat he is now Dr. Kreisle.

We also would like especially to thank Eric Schulz, who offered suggestions forthe book while at Williams College and has used the book in his classes atNorthwestern. Ken Brown and Matthew Eichner also tested the manuscript in theirclasses prior to publication. Ken also put together a thorough and extremely usefuldiary that related his experiences in using the first edition and offered many construc-tive suggestions for improving the presentation of key topics in the book. We also havebenefited from many helpful suggestions from Yossi Spiegel, Mort Kamien, Nabil Al-Najjar, Ambarish Chandra, Justin Braeutigam, and Kate Rockett.

Finally, we owe a large debt of gratitude to the students in Ron Braeutigams sec-tions of Economics 310-1 at Northwestern and to the students in Microeconomics430 at the Kellogg School at Northwestern. These students have helped us eliminatesome of the rough edges as the book has evolved over time. Their experience of learn-ing from the book helped make our chapters clearer and more accessible.

The development of this book was aided by colleagues who participated in focusgroups or reviewed early drafts of the manuscript. Our thanks go to all of the individ-uals listed below.

A C K N O W L E D G E M E N T S

x

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ACKNOWLEDGEMENTS xi

We are grateful for the comments we received from those who reviewed for the FifthEdition of this book:

Diane Bruce Anstine, North Central College; Peter Cheng, Baruch College of PublicAffairs, City University of New York; Matt Clements, St. Edwards University; SoniaDalmia, Grand Valley State University; Stephen B. Davis, Southwest MinnesotaState University; Craig Gallet, California State University, Sacramento; GuillermoE. Herrera, Bowdoin College; Hisaya Kitaoka, Franklin College; Daniel Lin,American University; Zinnia Mukherjee, Simmons College; Kathryn Nantz,Fairfield University; Elizabeth Perry-Sizemore, Randolph College; James E. Prieger,Pepperdine University School of Public Policy; Daniel E. Saros, ValparaisoUniversity; Stephen A. Woodbury, Michigan State University; and several otherswho wish to remain anonymous.

And from previous editions:

Anas Alhajji, Colorado School of Mines; Javad Amid, Uppsala University, Sweden;Shahina Amin, University of Northern Iowa; Scott Atkinson, University Of Georgia;Doris Bennett, Jacksonville State University; Arlo Biere, Kansas State University;Douglas Blair, Rutgers University; Michael Bognanno, Temple University; StephenBronars, University of Texas, Austin; Douglas Brown, Georgetown University;Kenneth Brown, University of Northern Iowa; Donald Bumpass, Sam Houston StateUniversity; James Burnell, College Of Wooster; Colin Campbell, Ohio StateUniversity; Corey S. Capps, University of Illinois; Tina A. Carter, Florida State University; Manual Carvajal, Florida International University; KousikChakrabarti, University of Michigan, Ann Arbor; Myong-Hun Chang, Cleveland StateUniversity; Ken Chapman, California State University; Yongmin Chen, University OfColorado-Boulder; Whewon Cho, Tennessee Technological University; Kui Kwon(Alice) Chong, University of North Carolina, Charlotte; Peter Coughlin, University ofMaryland; Paul Cowgill, Duke University; Steven Craig, University of Houston; MikeCurme, Miami University; Rudolph Daniels, Florida A&M University; Carl Davidson,Michigan State University; James Dearden, Lehigh University; Stacey Deirgerconlin,Syracuse University; Ron Deiter, Iowa State University; Martine Duchatelet, BarryUniversity; John Edwards, Tulane University; Matthew Eichner, Johns HopkinsUniversity; Ronel Elul, Brown University; Maxim Engers, University of Virginia;Eihab Fathelrahman, Washington State University, Vancouver; Raymond Fisman,Columbia University; Eric Friedman, Rutgers University; Susan Gensemer, SyracuseUniversity; Otis W. Gilley, California State University, Los Angeles; Steven MarcGoldman, University of California, Berkeley; Marvin A. Gordon, University of Illinoisat Chicago; Gregory Green, Indiana State University; Thomas Gresik, University OfNotre Dame; Barnali Gupta, Miami University; Umit Gurun, Michigan StateUniversity; Claire Hammond, Wake Forest University; Shawkat Hammoudeh, DrexelUniversity; Russell F. Hardy, University of New Mexico at Carlsbad; Dr. NaphtaliHoffman, Elmira University; Don Holley, Boise State University; Lyn Holmes, TempleUniversity; Eric Jamelske, University of Wisconsin, Eau Claire; Michael Jerison,State University of New York at Albany; Jiandong Ju, University of Oklahoma; David Kamerschen, University Of Georgia; Dean Karlan, Yale University; MaryKassis, State University of West Georgia; Donald Keenan, University of Georgia;

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xii ACKNOWLEDGEMENTS

Mark Killingsworth, Rutgers University; Philip King, San Francisco State University;Helen Knudsen, University of Pittsburgh; Charles Lamberton, South Dakota StateUniversity; Sang H. Lee, Southeastern Louisiana University; Donald Lien, Universityof Kansas; Qihong Liu, The University of Oklahoma; Leonard Loyd, University ofHouston; Mark Machina, University of California at San Diego; Mukul K. Manjumdar,Cornell University; Charles Mason, University of Wyoming; Gilbert Mathis, MurrayState University; Robert P. McComb, Texas Tech University; Michael McKee,University of New Mexico; Brian McManus, Washington University; ClaudioMezzetti, University of North Carolina; Peter Morgan, University of Michigan; JohnMoroney, Texas A&M University; John J. Nader, Grand Valley State University;Wilhelm Neuefeind, Washington University; Peter Norman, University of Wisconsin,Madison; Charles M. North, Baylor University; Mudziviri Nziramasanga, WashingtonState University; Iyatokunbo Okediji, University of Oklahoma; Zuohong Pan, WesternConnecticut State University; Silve Parviainen, University of Illinois; Ken Parzych,Eastern Connecticut State University; Richard M. Peck, University of Illinois,Chicago; Brian Peterson, Manchester College; Thomas Pogue, University of Iowa;Donald Pursell, University Of Nebraska, Lincoln; Michael Raith, University ofChicago; Sunder Ramaswamy, Middlebury College; Francisca G. C. Richter, ClevelandState University; Jeanne Ringel, Louisiana State University; Malcolm Robinson,Thomas More College; Robert Rosenman, Washington State University; PhilipRothman, East Carolina University; Santanu Roy, Florida International University;Christopher S. Ruebeck, Lafayette College; Jolyne Sanjak, State University of NewYork at Albany; David Schmidt, Indiana University; Barbara Schone, GeorgetownUniversity; Mark Schupack, Brown University; Konstantinos Serfes, State Universityof New York at Stony Brook; Richard Sexton, University of California, Davis; JasonShachat, University of California, San Diego; Brain Simboli, Lehigh University;Charles N. Steele, Montana State University; Maxwell Stinchcombe, University ofTexas, Austin; Beck Taylor, Baylor University; Curtis Taylor, Texas A&M University;Thomas Tenhoeve, Iowa State University; Mark Thoma, University of Oregon; JohnThompson, Louisiana State University; Paul Thistle, Western Michigan University;Guogiang Tian, Texas A&M University; Irene Trela, University of Western Ontario;Theofanis Tsoulouhas, North Carolina State University; Geoffrey Turnbull, LouisianaState University; Mich Tvede, University of Pennsylvania; Michele T. Villinski,Depauw University; Mark Walbert, Illinois University; Mark Walker, University ofArizona; Robert O. Weagley, Missouri State University; Larry Westphal, SwarthmoreCollege; Kealoha Widdows, Wabash College; Chiounan Yeh, Alabama StateUniversity.

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xiii

PART 1 INTRODUCTION TO MICROECONOMICSCHAPTER 1 Analyzing Economic Problems 1CHAPTER 2 Demand and Supply Analysis 26

APPENDIX: Price Elasticity of Demand Along a Constant Elasticity Demand Curve 74

PART 2 CONSUMER THEORYCHAPTER 3 Consumer Preferences and the Concept of Utility 75CHAPTER 4 Consumer Choice 105

APPENDIX 1: The Mathematics of Consumer Choice 145APPENDIX 2: The Time Value of Money 146

CHAPTER 5 The Theory of Demand 152

PART 3 PRODUCTION AND COST THEORYCHAPTER 6 Inputs and Production Functions 204

APPENDIX: The Elasticity of Substitution for a CobbDouglas Production Function 247CHAPTER 7 Costs and Cost Minimization 249

APPENDIX: Advanced Topics in Cost Minimization 285CHAPTER 8 Cost Curves 289

APPENDIX: Shephards Lemma and Duality 327

PART 4 PERFECT COMPETITIONCHAPTER 9 Perfectly Competitive Markets 331

APPENDIX: Profit Maximization Implies Cost Minimization 388CHAPTER 10 Competitive Markets: Applications 390

PART 5 MARKET POWERCHAPTER 11 Monopoly and Monopsony 442CHAPTER 12 Capturing Surplus 489

PART 6 IMPERFECT COMPETITION AND STRATEGIC BEHAVIORCHAPTER 13 Market Structure and Competition 532

APPENDIX: The Cournot Equilibrium and the Inverse Elasticity Pricing Rule 574CHAPTER 14 Game Theory and Strategic Behavior 575

PART 7 SPECIAL TOPICSCHAPTER 15 Risk and Information 608CHAPTER 16 General Equilibrium Theory 654

APPENDIX: Deriving the Demand and Supply Curves for General Equilibrium 698CHAPTER 17 Externalities and Public Goods 703

Mathematical Appendix 739

Solutions to Selected Problems 759Glossary 781Index 789

B R I E F C O N T E N T S

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xiv

CHAPTER 1 Analyzing Economic Problems 1

Microeconomics and Climate Change

1.1 Why Study Microeconomics? 4

1.2 Three Key Analytical Tools 5Constrained Optimization 6Equilibrium Analysis 12Comparative Statics 13

1.3 Positive and Normative Analysis 18

LEARNING-BY-DOING EXERCISES1.1 Constrained Optimization: The Farmers Fence 71.2 Constrained Optimization: Consumer Choice 81.3 Comparative Statics with Market Equilibrium in the

U.S. Market for Corn 161.4 Comparative Statics with Constrained

Optimization 18

CHAPTER 2 Demand and Supply Analysis 26

What Gives with the Price of Corn?

2.1 Demand, Supply, and Market Equilibrium 29Demand Curves 30Supply Curves 32Market Equilibrium 33Shifts in Supply and Demand 35

2.2 Price Elasticity of Demand 45Elasticities Along Specific Demand Curves 47Price Elasticity of Demand and Total Revenue 49Determinants of the Price Elasticity of Demand 50

C O N T E N T S

PART 1 INTRODUCTION TO MICROECONOMICS

Market-Level versus Brand-Level Price Elasticities of Demand 51

2.3 Other Elasticities 53Income Elasticity of Demand 53Cross-Price Elasticity of Demand 54Price Elasticity of Supply 56

2.4 Elasticity in the Long Run versus the Short Run 56

Greater Elasticity in the Long Run Than in the Short Run 56

Greater Elasticity in the Short Run Than in the Long Run 58

2.5 Back-of-the-Envelope Calculations 59Fitting Linear Demand Curves Using Quantity, Price,

and Elasticity Information 60Identifying Supply and Demand Curves on the Back of an

Envelope 61Identifying the Price Elasticity of Demand from

Shifts in Supply 63

APPENDIX Price Elasticity of Demand Along aConstant Elasticity Demand Curve 74

LEARNING-BY-DOING EXERCISES2.1 Sketching a Demand Curve 312.2 Sketching a Supply Curve 332.3 Calculating Equilibrium Price and Quantity 342.4 Comparative Statics on the Market

Equilibrium 372.5 Price Elasticity of Demand 472.6 Elasticities along Special Demand Curves 49

PART 2 CONSUMER THEORY

CHAPTER 3 Consumer Preferences and the Concept of Utility 75

Why Do You Like What You Like?

3.1 Representations of Preferences 77Assumptions About Consumer Preferences 77Ordinal and Cardinal Ranking 79

3.2 Utility Functions 80Preferences with a Single Good: The Concept of

Marginal Utility 80Preferences with Multiple Goods: Marginal Utility, Indifference

Curves, and the Marginal Rate of Substitution 84

3.3 Special Preferences 95Perfect Substitutes 95Perfect Complements 96The CobbDouglas Utility Function 97Quasilinear Utility Functions 98

LEARNING-BY-DOING EXERCISES3.1 Marginal Utility 853.2 Marginal Utility That Is Not Diminishing 863.3 Indifference Curves with Diminishing

MRSx,y 933.4 Indifference Curves with Increasing MRSx,y 94

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CHAPTER 4 Consumer Choice 105

How Much of What You Like Should You Buy?

4.1 The Budget Constraint 107How Does a Change in Income Affect the

Budget Line? 109How Does a Change in Price Affect the

Budget Line? 109

4.2 Optimal Choice 112Using the Tangency Condition to Understand When

a Basket Is Not Optimal 116Finding an Optimal Consumption Basket 117Two Ways of Thinking About Optimality 118Corner Points 120

4.3 Consumer Choice with Composite Goods 123Application: Coupons and Cash Subsidies 123Application: Joining a Club 127Application: Borrowing and Lending 128Application: Quantity Discounts 133

4.4 Revealed Preference 134Are Observed Choices Consistent with Utility

Maximization? 135

APPENDIX 1 The Mathematics of Consumer Choice 145

APPENDIX 2 The Time Value of Money 146

LEARNING-BY-DOING EXERCISES4.1 Good News/Bad News and the Budget Line 1124.2 Finding an Interior Optimum 1174.3 Finding a Corner Point Solution 1214.4 Corner Point Solution with Perfect

Substitutes 1224.5 Consumer Choice That Fails to Maximize Utility 1364.6 Other Uses of Revealed Preference 138

CHAPTER 5 The Theory of Demand 152

Why Understanding the Demand for Cigarettes IsImportant for Public Policy

5.1 Optimal Choice and Demand 154The Effects of a Change in Price 154The Effects of a Change in Income 157

The Effects of a Change in Price or Income: An AlgebraicApproach 162

5.2 Change in the Price of a Good: SubstitutionEffect and Income Effect 164

The Substitution Effect 165The Income Effect 165Income and Substitution Effects When Goods Are Not

Normal 167

5.3 Change in the Price of a Good: The Concept of Consumer Surplus 175

Understanding Consumer Surplus from theDemand Curve 175

Understanding Consumer Surplus from the Optimal Choice Diagram: Compensating Variation and Equivalent Variation 177

5.4 Market Demand 184Market Demand with Network Externalities 186

5.5 The Choice of Labor and Leisure 189As Wages Rise, Leisure First Decreases, Then

Increases 189The Backward-Bending Supply of Labor 191

5.6 Consumer Price Indices 195

LEARNING-BY-DOING EXERCISES5.1 A Normal Good Has a Positive Income Elasticity

of Demand 1615.2 Finding a Demand Curve (No Corner Points) 1625.3 Finding a Demand Curve (with a Corner

Point Solution) 1635.4 Finding Income and Substitution Effects

Algebraically 1705.5 Income and Substitution Effects with

a Price Increase 1725.6 Income and Substitution Effects with a Quasilinear

Utility Function 1735.7 Consumer Surplus: Looking at the Demand Curve 1765.8 Compensating and Equivalent Variations with No

Income Effect 1805.9 Compensating and Equivalent Variations with

an Income Effect 1825.10 The Demand for Leisure and the Supply

of Labor 193

CHAPTER 6 Inputs and Production Functions 204

Can They Do It Better and Cheaper?

6.1 Introduction to Inputs and Production Functions 206

6.2 Production Functions with a Single Input 208

Total Product Functions 209Marginal and Average Product 210Relationship Between Marginal and Average Product 214

6.3 Production Functions with More Than One Input 214

Total Product and Marginal Product with Two Inputs 214Isoquants 216

PART 3 PRODUCTION AND COST THEORY

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Economic and Uneconomic Regions of Production 220

Marginal Rate of Technical Substitution 221

6.4 Substitutability Among Inputs 223Describing a Firms Input Substitution Opportunities

Graphically 224Elasticity of Substitution 226Special Production Functions 229

6.5 Returns to Scale 234Definitions 234Returns to Scale versus Diminishing Marginal

Returns 237

6.6 Technological Progress 237

APPENDIX The Elasticity of Substitution fora CobbDouglas Production Function 247

LEARNING-BY-DOING EXERCISES6.1 Deriving the Equation of an Isoquant 2206.2 Relating the Marginal Rate of Technical Substitution

to Marginal Products 2236.3 Calculating the Elasticity of Substitution from

a Production Function 2276.4 Returns to Scale for a CobbDouglas Production

Function 2366.5 Technological Progress 239

CHAPTER 7 Costs and Cost Minimization 249

Whats Behind the Self-Service Revolution?

7.1 Cost Concepts for Decision Making 251Opportunity Cost 251Economic versus Accounting Costs 254Sunk (Unavoidable) versus Nonsunk (Avoidable)

Costs 255

7.2 The Cost-Minimization Problem 257Long Run versus Short Run 257The Long-Run Cost-Minimization Problem 258Isocost Lines 259Graphical Characterization of the Solution to the

Long-Run Cost-Minimization Problem 260Corner Point Solutions 262

7.3 Comparative Statics Analysis of the Cost-Minimization Problem 264

Comparative Statics Analysis of Changes in Input Prices 264

Comparative Statics Analysis of Changes in Output 268

Summarizing the Comparative Statics Analysis: The Input Demand Curves 269

The Price Elasticity of Demand for Inputs 271

7.4 Short-Run Cost Minimization 273Characterizing Costs in the Short Run 274Cost Minimization in the Short Run 276

Comparative Statics: Short-Run Input Demand versus Long-Run Input Demand 277

More Than One Variable Input in the Short Run 278

APPENDIX Advanced Topics in Cost Minimization 285

LEARNING-BY-DOING EXERCISES7.1 Using the Cost Concepts for a College Campus

Business 2567.2 Finding an Interior Cost-Minimization

Optimum 2627.3 Finding a Corner Point Solution with Perfect

Substitutes 2637.4 Deriving the Input Demand Curves from a Production

Function 2717.5 Short-Run Cost Minimization with One

Fixed Input 2787.6 Short-Run Cost Minimization with Two Variable

Inputs 279

CHAPTER 8 Cost Curves 289

How Can HiSense Get a Handle on Costs?

8.1 Long-Run Cost Curves 291Long-Run Total Cost Curve 291How Does the Long-Run Total Cost Curve Shift When

Input Prices Change? 293Long-Run Average and Marginal Cost Curves 296

8.2 Short-Run Cost Curves 306Short-Run Total Cost Curve 306Relationship Between the Long-Run and the Short-Run

Total Cost Curves 307Short-Run Average and Marginal Cost Curves 309Relationships Between the Long-Run and the Short-Run

Average and Marginal Cost Curves 310When Are Long-Run and Short-Run Average and Marginal

Costs Equal, and When Are They Not? 311

8.3 Special Topics in Cost 314Economies of Scope 314Economies of Experience: The Experience

Curve 317

8.4 Estimating Cost Functions 319Constant Elasticity Cost Function 320Translog Cost Function 320

APPENDIX Shephards Lemma and Duality 327

LEARNING-BY-DOING EXERCISES8.1 Finding the Long-Run Total Cost Curve from a

Production Function 2928.2 Deriving Long-Run Average and Marginal Cost

Curves from a Long-Run Total Cost Curve 2988.3 Deriving a Short-Run Total Cost Curve 3078.4 The Relationship Between Short-Run and Long-Run

Average Cost Curves 312

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PART 4 PERFECT COMPETITION

CHAPTER 9 Perfectly Competitive Markets 331

A Rose Is a Rose Is a Rose

9.1 What Is Perfect Competition? 333

9.2 Profit Maximization by a Price-Taking Firm 336Economic Profit versus Accounting Profit 336The Profit-Maximizing Output Choice for a

Price-Taking Firm 338

9.3 How the Market Price Is Determined: Short-Run Equilibrium 341

The Price-Taking Firms Short-Run Cost Structure 341Short-Run Supply Curve for a Price-Taking Firm

When All Fixed Costs Are Sunk 343Short-Run Supply Curve for a Price-Taking Firm When

Some Fixed Costs Are Sunk and Some Are Nonsunk 345

Short-Run Market Supply Curve 349Short-Run Perfectly Competitive Equilibrium 352Comparative Statics Analysis of the Short-Run

Equilibrium 353

9.4 How the Market Price Is Determined: Long-Run Equilibrium 356

Long-Run Output and Plant-Size Adjustments byEstablished Firms 356

The Firms Long-Run Supply Curve 357Free Entry and Long-Run Perfectly Competitive

Equilibrium 358Long-Run Market Supply Curve 360Constant-Cost, Increasing-Cost, and Decreasing-Cost

Industries 362What Does Perfect Competition Teach Us? 370

9.5 Economic Rent and Producer Surplus 371Economic Rent 371Producer Surplus 374Economic Profit, Producer Surplus, Economic Rent 380

APPENDIX Profit Maximization Implies Cost Minimization 388

LEARNING-BY-DOING EXERCISES9.1 Deriving the Short-Run Supply Curve for a

Price-Taking Firm 3459.2 Deriving the Short-Run Supply Curve for a Price-Taking

Firm with Some Nonsunk Fixed Costs 3479.3 Short-Run Market Equilibrium 3539.4 Calculating a Long-Run Equilibrium 3609.5 Calculating Producer Surplus 379

CHAPTER 10 Competitive Markets:Applications 390

Is Support a Good Thing?

10.1 The Invisible Hand, Excise Taxes and Subsidies 392

The Invisible Hand 393Excise Taxes 394Incidence of a Tax 398Subsidies 402

10.2 Price Ceilings and Floors 404Price Ceilings 405Price Floors 412

10.3 Production Quotas 417

10.4 Price Supports in the Agricultural Sector 421Acreage Limitation Programs 422Government Purchase Programs 422

10.5 Import Quotas and Tariffs 426Quotas 426Tariffs 429

LEARNING-BY-DOING EXERCISES10.1 Impact of an Excise Tax 39710.2 Impact of a Subsidy 40410.3 Impact of a Price Ceiling 41110.4 Impact of a Price Floor 41610.5 Comparing the Impact of an Excise Tax, a Price Floor,

and a Production Quota 42110.6 Effects of an Import Tariff 432

PART 5 MARKET POWER

CHAPTER 11 Monopoly and Monopsony 442

Why Do Firms Play Monopoly?

11.1 Profit Maximization by a Monopolist 444The Profit-Maximization Condition 444A Closer Look at Marginal Revenue: Marginal Units and

Inframarginal Units 448Average Revenue and Marginal Revenue 449The Profit-Maximization Condition Shown

Graphically 451A Monopolist Does Not Have a Supply Curve 453

11.2 The Importance of Price Elasticity of Demand 454

Price Elasticity of Demand and the Profit-MaximizingPrice 454

Marginal Revenue and Price Elasticity of Demand 455Marginal Cost and Price Elasticity of Demand: The Inverse

Elasticity Pricing Rule 457The Monopolist Always Produces on the Elastic Region

of the Market Demand Curve 458The IEPR Applies Not Only to Monopolists 460Quantifying Market Power: The Lerner Index 461

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11.3 Comparative Statics for Monopolists 462Shifts in Market Demand 462Shifts in Marginal Cost 465

11.4 Monopoly with Multiple Plants and Markets 467

Output Choice with Two Plants 467Output Choice with Two Markets 469Profit Maximization by a Cartel 470

11.5 The Welfare Economics of Monopoly 473The Monopoly Equilibrium Differs from the Perfectly

Competitive Equilibrium 473Monopoly Deadweight Loss 475Rent-Seeking Activities 475

11.6 Why Do Monopoly Markets Exist? 475Natural Monopoly 476Barriers to Entry 477

11.7 Monopsony 479The Monopsonists Profit-Maximization Condition 479An Inverse Elasticity Pricing Rule for Monopsony 481Monopsony Deadweight Loss 482

LEARNING-BY-DOING EXERCISES11.1 Marginal and Average Revenue for a Linear Demand

Curve 45111.2 Applying the Monopolists Profit-Maximization

Condition 45311.3 Computing the Optimal Monopoly Price for a

Constant Elasticity Demand Curve 45711.4 Computing the Optimal Monopoly Price for a Linear

Demand Curve 45811.5 Computing the Optimal Price Using the Monopoly

Midpoint Rule 46411.6 Determining the Optimal Output, Price, and Division

of Production for a Multiplant Monopolist 46911.7 Determining the Optimal Output and Price for a

Monopolist Serving Two Markets 47011.8 Applying the Monopsonists Profit-Maximization

Condition 480

11.9 Applying the Inverse Elasticity Rule for a Monopsonist 482

CHAPTER 12 Capturing Surplus 489

Why Did Your Carpet or Your Airline Ticket Cost So

Much Less Than Mine?

12.1 Capturing Surplus 491

12.2 First-Degree Price Discrimination: Making theMost from Each Consumer 494

12.3 Second-Degree Price Discrimination: Quantity Discounts 499

Block Pricing 499Subscription and Usage Charges 502

12.4 Third-Degree Price Discrimination: DifferentPrices for Different Market Segments 505

Two Different Segments, Two Different Prices 505Screening 508Third-Degree Price Discrimination with Capacity Constraints 510Implementing the Scheme of Price Discrimination:

Building Fences 512

12.5 Tying (Tie-In Sales) 516Bundling 517Mixed Bundling 519

12.6 Advertising 522

LEARNING-BY-DOING EXERCISES12.1 Capturing Surplus: Uniform Pricing versus

First-Degree Price Discrimination 49612.2 Where Is the Marginal Revenue Curve with

First-Degree Price Discrimination? 49712.3 Increasing Profits with a Block Tariff 50112.4 Third-Degree Price Discrimination in Railroad

Transport 50712.5 Third-Degree Price Discrimination for Airline Tickets 50912.6 Price Discrimination Subject to Capacity Constraints 51112.7 Markup and Advertising-to-Sales Ratio 524

PART 6 IMPERFECT COMPETITION AND STRATEGIC BEHAVIOR

CHAPTER 13 Market Structure andCompetition 532

Is Competition Always the Same? If Not, Why Not?

13.1 Describing and Measuring Market Structure 534

13.2 Oligopoly with Homogeneous Products 537The Cournot Model of Oligopoly 537The Bertrand Model of Oligopoly 545Why Are the Cournot and Bertrand Equilibria

Different? 547The Stackelberg Model of Oligopoly 548

13.3 Dominant Firm Markets 550

13.4 Oligopoly with Horizontally DifferentiatedProducts 553

What Is Product Differentiation? 553Bertrand Price Competition with Horizontally

Differentiated Products 556

13.5 Monopolistic Competition 562Short-Run and Long-Run Equilibrium in Monopolistically

Competitive Markets 562Price Elasticity of Demand, Margins, and Number of Firms

in the Market 564Do Prices Fall When More Firms Enter? 564

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CONTENTS xix

APPENDIX The Cournot Equilibrium and the Inverse Elasticity Pricing Rule 574

LEARNING-BY-DOING EXERCISES13.1 Computing a Cournot Equilibrium 54013.2 Computing the Cournot Equilibrium for Two or

More Firms with Linear Demand 54413.3 Computing the Equilibrium in the Dominant Firm

Model 55213.4 Computing a Bertrand Equilibrium with Horizontally

Differentiated Products 560

CHAPTER 14 Game Theory and StrategicBehavior 575

Whats in a Game?

14.1 The Concept of Nash Equilibrium 577A Simple Game 577

The Nash Equilibrium 578The Prisoners Dilemma 578Dominant and Dominated Strategies 579Games with More Than One Nash Equilibrium 583Mixed Strategies 586Summary: How to Find All the Nash Equilibria in a

Simultaneous-Move Game with Two Players 588

14.2 The Repeated Prisoners Dilemma 588

14.3 Sequential-Move Games and Strategic Moves 594Analyzing Sequential-Move Games 594The Strategic Value of Limiting Ones Options 597

LEARNING-BY-DOING EXERCISES14.1 Finding the Nash Equilibrium: Coke versus Pepsi 58214.2 Finding All of the Nash Equilibria in a Game 58614.3 An Entry Game 596

PART 7 SPECIAL TOPICS

CHAPTER 15 Risk and Information 608

Risky Business

15.1 Describing Risky Outcomes 610Lotteries and Probabilities 610Expected Value 612Variance 612

15.2 Evaluating Risky Outcomes 615Utility Functions and Risk Preferences 615Risk-Neutral and Risk-Loving Preferences 618

15.3 Bearing and Eliminating Risk 621Risk Premium 621When Would a Risk-Averse Person Choose to Eliminate

Risk? The Demand for Insurance 624Asymmetric Information in Insurance Markets: Moral

Hazard and Adverse Selection 627

15.4 Analyzing Risky Decisions 633Decision Tree Basics 633Decision Trees with a Sequence of Decisions 635The Value of Information 637

15.5 Auctions 639Types of Auctions and Bidding Environments 640Auctions When Bidders Have Private Values 641Auctions When Bidders Have Common Values:

The Winners Curse 645

LEARNING-BY-DOING EXERCISES15.1 Computing the Expected Utility for Two Lotteries

for a Risk-Averse Decision Maker 61815.2 Computing the Expected Utility for Two Lotteries:

Risk-Neutral and Risk-Loving Decision Makers 62015.3 Computing the Risk Premium from a Utility

Function 624

15.4 The Willingness to Pay for Insurance 62515.5 Verifying the Nash Equilibrium in a First-Price

Sealed-Bid Auction with Private Values 642

CHAPTER 16 General Equilibrium Theory 654

How Do Gasoline Taxes Affect the Economy?

16.1 General Equilibrium Analysis: Two Markets 656

16.2 General Equilibrium Analysis: Many Markets 660

The Origins of Supply and Demand in a Simple Economy 660

The General Equilibrium in Our Simple Economy 666Walras Law 670

16.3 General Equilibrium Analysis: ComparativeStatics 671

16.4 The Efficiency of Competitive Markets 675What Is Economic Efficiency? 675Exchange Efficiency 676Input Efficiency 682Substitution Efficiency 684Pulling the Analysis Together: The Fundamental Theorems

of Welfare Economics 687

16.5 Gains from Free Trade 688Free Trade Is Mutually Beneficial 688Comparative Advantage 692

APPENDIX Deriving the Demand and Supply Curvesfor General Equilibrium in Figure 16.9 and Learning-by-Doing Exercise 16.2 698

LEARNING-BY-DOING EXERCISES16.1 Finding the Prices at a General Equilibrium with

Two Markets 660

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xx CONTENTS

16.2 Finding the Conditions for a General Equilibrium with Four Markets 669

16.3 Checking the Conditions for Exchange Efficiency 680

CHAPTER 17 Externalities and Public Goods 703

When Does the Invisible Hand Fail?

17.1 Introduction 705

17.2 Externalities 706Negative Externalities and Economic Efficiency 708

Positive Externalities and Economic Efficiency 722Property Rights and the Coase Theorem 726

17.3 Public Goods 728Efficient Provision of a Public Good 729The Free-Rider Problem 732

LEARNING-BY-DOING EXERCISES17.1 The Efficient Amount of Pollution 71117.2 Emissions Fee 71417.3 The Coase Theorem 72717.4 Optimal Provision of a Public Good 731

Mathematical Appendix 739

Solutions to Selected Problems 759

Glossary 781

Index 789

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11.1 WHY STUDY MICROECONOMICS?

1.2 THREE KEY ANALYTICAL TOOLS

APPLICATION 1.1 Generating Electricity: 8,760 Decisions per Year

APPLICATION 1.2 The Toughest Ticket in Sports

1.3 POSITIVE AND NORMATIVE ANALYSIS

APPLICATION 1.3 Positive and Normative Analyses of the Minimum Wage

Microeconomics and Climate ChangeBy the late 2000s, the scientific consensus had formed: climate change is for real, and it cannot be

explained entirely by natural forces:

There is compelling scientific evidence that concentrations of greenhouse gassescompounds such as

carbon dioxide and methane whose properties work to warm surface temperatures on the Earth

have accumulated to levels substantially higher than those that prevailed at any time during the last

500,000 years.

There is strong evidence that the climate is warming. According to the Fourth Assessment of the

Intergovernmental Panel on Climate Change (IPCC) issued in 2007the best representation of the

scientific consensus on climate changeWarming of the climate system is unequivocal, as is now

evident from observations of increases in global average air and ocean temperatures, widespread

melting of snow and ice, and rising global average sea level.1

1Summary for Policymakers in Climate Change 2007: The Physical Science Basis. Contributions of Working Group I to the Fourth AssessmentReport of the Intergovernmental Panel on Climate Change, S. Soloman, D. Qin, M. Manning, Z. Chen, M. Marquis, K. B. Avery, M. Tignor,and H. L. Mikllers (eds.) (Cambridge: Cambridge University Press 2007), p. 5. http://www.ipcc.ch/ipccreports/ar4-wg1.htm (accessedApril 3, 2009).

Analyzing EconomicProblems

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2 There is persuasive evidence that climate change has

been induced, in part, by humans. According to the IPCC:

The common conclusion of a wide range of fingerprint

studies conducted over the last 15 years is that observed

climate changes cannot be explained by natural factors

alone.2

But if the diagnosis of climate change is unequivocal,

what to do about it is less obvious. Greenhouse gas emissions

come from power plants, factories, and automobiles all over

the world. The number of pollution sources that potentially

need to be controlled is mind-boggling. And large countries

such as China and the United States, the two countries

accounting for the largest share of greenhouse gas emissions, might balk at the enormous price tag asso-

ciated with curtailing their emissions. In light of these issues, the challenge of combating global climate

change would appear to be insurmountable.

Microeconomics offers powerful insights into why climate change is such a difficult problem and

what to do about it. Climate change is a tough problem to deal with because the parties that cause

greenhouse gas emissions are unlikely to take into account the environmental harm that their deci-

sions cause for others. For example, economists estimate that in the mid-2000s, the typical American

household caused about $150 annually in environmental damage by consuming products or services

that caused greenhouse gas emissions.3 Did you or your family take this into account when you

made decisions about how much electricity to use or how much to drive? Probably not. After all, you

did not have to pay this cost, either directly (because no one directly charged you for this cost) or

indirectly (because it was not reflected in the price of the products you consumed because the

producers of those products were not charged for this cost). New York Times columnist Tom

Friedman puts it this way:

[I]f I had my wish, the leaders of the worlds 20 top economies would commit themselves to a newstandard of accountingcall it Market to Mother Nature accounting. Why? Becouse its now obvi-ous that the reason were experiencing a simultaneous meltdown in the financial system and the climate system is because we have been mispricing risk in both arenasproducing a huge excess ofboth toxic assets and toxic air that now threatens the stability of the whole planet.

Just as A.I.G. sold insurance derivatives at prices that did not reflect the real costs and the real risksof massive defaults (for which we the taxpayers ended up paying the difference), oil companies, coalcompanies and electric utilities today are selling energy products at prices that do not reflect thereal costs to the environment and real risks of disruptive climate change (so future taxpayers willend up paying the difference).4

2H. R. Le Treut, R. Somerville, U. Cubasch, Y. Ding, C. Mauritzen, A. Mokssit, T. Peterson, and M. Prather, Historical Overview of Climate Change, in Climate Change 2007: The Physical Science Basis, p. 103.3The estimate of the social cost of electricity usage comes from W. Nordhaus, A Question of Balance: Weighing the Options on GlobalWarming Policies (New Haven, CT: Yale University Press, 2008), p. 11.4The Price Is Not Right, New York Times (March 31, 2009).

James Richey/iStockphoto

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But Friedmans diagnosis of the problem is also suggestive of a solution: to induce parties to make

decisions that reflect the real costs of climate change, find a way to put a price on the harm that

greenhouse gas emissions cause to the climate and the economy. Basic ideas from microeconomics are

being applied today to help do this. Consider, for example, the European Union (EU) Emissions Trading

System. Under the provisions of the Kyoto Treaty, the countries of the EU must reduce their emissions

of greenhouse gases 8 percent below their emissions in 1990. To do so, the EU has adopted what is

called a cap-and-trade system.5

A cap-and-trade system applies microeconomics to achieve a given amount of pollution reduction at

a cost as low as possible. Heres how it works. Caps are placed on how much of a greenhouse gas, say

carbon dioxide (CO2), can be emitted from specific sources (e.g., power plants or factories). At the same

time, CO2 permits are granted to the firms that own those sources of CO2 pollution, allowing them to

emit a given amount of CO2 within a given period of time. Firms are then free to trade these permits in

an open market. The idea behind this scheme is that a firm that can cheaply reduce its CO2 emissions

below its cap (e.g., by installing pollution control equipment), and can sell its allowances to other firms

for whom pollution control would be more expensive. The beauty of this systemwhich follows

directly from the fact that it is market-basedis that reductions in emissions of a given amount are

achieved as cheaply as possible. Moreover, a government (or group of governments as in the case of

the EU) does not need to know which firms can reduce pollution more cheaply. The free market

identifies those firms through the purchase and sale of permits: firms with low costs of compliance sell

permits; firms with high costs of compliance buy them. By reducing the supply of allowances over time,

the government can reduce pollution, all the while being assured that the reduction is done at as low

a cost as is possible.

Microeconomics is a field of study that has broad applicability. It can help public policy makers deal

with difficult issues such as climate change, and it can help those same public officials anticipate the

unintended consequences of the policies they adopt. For example, microeconomic analyses of cap-and-

trade systems reveal that while a cap-and-trade system offers the potential to correctly price greenhouse

gas emissions, there are circumstances under which this system can result in significant underpricing

or overpricing of those emissions if policy makers make even small mistakes in setting the cap.6

Microeconomics can also help business firms better understand their competitive environments, and it can

give them concrete tools that can be used to unlock additional profitability through pricing strategies. It

can help us understand how households consumption decisions are shaped by the fundamentals (e.g.,

tastes and price levels) they face, and it can shed light on why prices in competitive markets fluctuate as

they do. Microeconomics can even help us understand social phenomena such as crime and marriage

(yes, economists have even studied these). Whats remarkable is that nearly all phenomena studied by

3

5The Kyoto Treaty was adopted in the late 1990s, and it called for industrialized countries to scale back the amount of greenhouse gases.The treaty was ratified by EU counties, but not by the United States.6See, for example, W. J. McKibbin and P. J. Wilcoxen, The Role of Economics in Climate Change Policy, Journal of Economic Perspectives,16, no. 2 (Spring 2002): 107129.

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economists rely on three powerful analytical tools: constrained optimization, equilibrium analysis, and

comparative statics.

CHAPTER PREVIEW After reading and studying this chapter, you will be able to:

Contrast the two main branches of economicsmicroeconomics and macroeconomics.

Describe the three main analytical tools of microeconomicsconstrained optimization, equilibrium

analysis, and comparative staticsand recognize examples of each of these tools.

Explain the difference between positive and normative analysis.

4

Economics is the science that deals with the allocation of limited resources to sat-isfy unlimited human wants. Think of human wants as being all the goods andservices that individuals desire, including food, clothing, shelter, and anything elsethat enhances the quality of life. Since we can always think of ways to improve ourwell-being with more or better goods and services, our wants are unlimited.However, to produce goods and services, we need resources, including labor, mana-gerial talent, capital, and raw materials. Resources are said to be scarce because theirsupply is limited. The scarcity of resources means that we are constrained in thechoices we can make about the goods and services we produce, and thus also aboutwhich human wants we will ultimately satisfy. That is why economics is oftendescribed as the science of constrained choice.

Broadly speaking, economics is composed of two branches, microeconomics andmacroeconomics. The prefix micro is derived from the Greek word mikros, whichmeans small. Microeconomics therefore studies the economic behavior of individ-ual economic decision makers, such as a consumer, a worker, a firm, or a manager. Italso analyzes the behavior of individual households, industries, markets, labor unions,or trade associations. By contrast, the prefix macro comes from the Greek word makros,which means large. Macroeconomics thus analyzes how an entire national economyperforms. A course in macroeconomics would examine aggregate levels of income andemployment, the levels of interest rates and prices, the rate of inflation, and the na-ture of business cycles in a national economy.

Constrained choice is important in both macroeconomics and microeconomics.For example, in macroeconomics we would see that a society with full employmentcould produce more goods for national defense, but it would then have to producefewer civilian goods. It might use more of its depletable natural resources, such asnatural gas, coal, and oil, to manufacture goods today, in which case it would con-serve less of these resources for the future. In a microeconomic setting, a consumermight decide to allocate more time to work, but would then have less time availablefor leisure activities. The consumer could spend more income on consumptiontoday, but would then save less for tomorrow. A manager might decide to spend moreof a firms resources on advertising, but this might leave less available for researchand development.

Every society has its own way of deciding how to allocate its scarce resources.Some resort to a highly centralized organization. For example, during the Cold War,governmental bureaucracies heavily controlled the allocation of resources in the

1.1WHY STUDYMICRO-ECONOMICS?

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1.2 THREE KEY ANALYTICAL TOOLS 5

economies of Eastern Europe and the Soviet Union. Other countries, such as those inNorth America or Western Europe, have historically relied on a mostly decentralizedmarket system to allocate resources. Regardless of its market system, every societymust answer these questions:

What goods and services will be produced, and in what quantities? Who will produce the goods and services, and how? Who will receive the goods and services?

Microeconomic analysis attempts to answer these questions by studying thebehavior of individual economic units. By answering questions about how consumersand producers behave, microeconomics helps us understand the pieces that collec-tively make up a model of an entire economy. Microeconomic analysis also providesthe foundation for examining the role of the government in the economy and the ef-fects of government actions. Microeconomic tools are commonly used to addresssome of the most important issues in contemporary society. These include (but arenot limited to) pollution, rent controls, minimum wage laws, import tariffs and quo-tas, taxes and subsidies, food stamps, government housing and educational assistanceprograms, government health care programs, workplace safety, and the regulation ofprivate firms.

exogenous variableA variable whose value istaken as given in the analy-sis of an economic system.

endogenous variableA variable whose value isdetermined within the eco-nomic system being studied.

1.2THREE KEYANALYTICALTOOLS

To study real phenomena in a world that is exceedingly complex, economists con-struct and analyze economic models, or formal descriptions, of the problems theyare addressing. An economic model is like a roadmap. A roadmap takes a complexphysical reality (terrain, roads, houses, stores, parking lots, alleyways, and other fea-tures) and strips it down to bare essentials: major streets and highways. Theroadmap is an abstract model that serves a particular purposeit shows us where weare and how we can get where we want to go. To provide a clear representation ofreality, it ignores or abstracts from much of the rich detail (the location of beau-tiful elm trees or stately homes, for example) that makes an individual town uniqueand charming.

Economic models operate in much the same way. For example, to understandhow a drought in Colombia might affect the price of coffee in the United States, aneconomist might employ a model that ignores much of the rich detail of the indus-try, including some aspects of its history or the personalities of the people who workin the fields. These details might make an interesting article in Business Week, butthey do not help us understand the fundamental forces that determine the price ofcoffee.

Any model, whether it is used to study chemistry, physics, or economics, mustspecify what variables will be taken as given in the analysis and what variables areto be determined by the model. This brings us to the important distinction be-tween exogenous and endogenous variables. An exogenous variable is one whosevalue is taken as given in a model. In other words the value of an exogenous vari-able is determined by some process outside the model being examined. An en-dogenous variable is a variable whose value is determined within the model beingstudied.

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6 CHAPTER 1 ANALYZING ECONOMIC PROBLEMS

To understand the distinction, suppose you want to build a model to predict howfar a ball will fall after it is released from the top of a tall building. You might assumethat certain variables, such as the force of gravity and the density of the air throughwhich the ball must pass, are taken as given (exogenous) in your analysis. Given the exogenous variables, your model will describe the relationship between the distancethe ball will drop and the time elapsed after it is released. The distance and time pre-dicted by your model are endogenous variables.

Nearly all microeconomic models rely on just three key analytical tools. We believethis makes microeconomics unique as a field of study. No matter what the specific issueiscoffee prices in the United States, or decision making by firms on the Internetmicroeconomics uses the same three analytical tools:

Constrained optimization Equilibrium analysis Comparative statics

Throughout this book, we will apply these tools to microeconomic problems.This section introduces these three tools and provides examples of how they can beemployed. Do not expect to master these tools just by reading this chapter. Rather,you should learn to recognize them when we apply them in later chapters.

CONSTRAINED OPTIMIZATIONAs we noted earlier, economics is the science of constrained choice. The tool of con-strained optimization is used when a decision maker seeks to make the best (opti-mal) choice, taking into account any possible limitations or restrictions on the choices.We can therefore think about constrained optimization problems as having two parts,an objective function and a set of constraints. An objective function is the relation-ship that the decision maker seeks to optimize, that is, either maximize or minimize.For example, a consumer may want to purchase goods to maximize her satisfaction. Inthis case, the objective function would be the relationship that describes how satisfiedshe will be when she purchases any particular set of goods. Similarly, a producer maywant to plan production activities to minimize the costs of manufacturing its product.Here the objective function would show how the total costs of production depend onthe various production plans available to the firm.

Decision makers must also recognize that there are often restrictions on the choicesthey may actually select. These restrictions reflect the fact that resources are scarce, orthat for some other reason only certain choices can be made. The constraints in a con-strained optimization problem represent restrictions or limits that are imposed on thedecision maker.

Examples of Constrained OptimizationTo make sure that the difference between an objective function and a constraint is clear,lets consider two examples. See if you can identify the objective function and the con-straint in each example. (Do not attempt to solve the problems. We will present tech-niques for solving them in later chapters. At this stage the important point is simplyto understand examples of constrained optimization problems.)

constrained optimiza-tion An analytical tool formaking the best (optimal)choice, taking into accountany possible limitations orrestrictions on the choice.

objective functionThe relationship that a decision maker seeks tomaximize or minimize.

constraints The restric-tions or limits imposed on a decision maker in a constrained optimization problem.

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1.2 THREE KEY ANALYTICAL TOOLS 7

By convention, economists usually state a constrained optimization problem likethe one facing the farmer in Learning-By-Doing Exercise 1.1 in the following way:

max LW(L,W )

subject to: 2L 2W F

The first line identifies the objective function, the area LW, and tells whether it isto be maximized or minimized. (If the objective function were to be minimized, maxwould be min.) Underneath the max is a list of the endogenous variables that thedecision maker (the farmer) controls; in this example, (L, W ) indicates that thefarmer can choose the length and the width of the pen.

The second line represents the constraint on the perimeter. It tells us that thefarmer can choose L and W as long as (subject to the constraint that) the perimeterdoes not exceed F. Taken together, the two lines of the problem tell us that the farmerwill choose L and W to maximize the area, but those choices are subject to the con-straint on the amount of fence available.

We now illustrate the concept of constrained optimization with a famous problemin microeconomics, consumer choice. (Consumer choice will be analyzed in depth inChapters 3, 4, and 5.)

Marginal Reasoning and Constrained OptimizationConstrained optimization analysis can reveal that the obvious answers to economicquestions may not always be correct. We will illustrate this point by showing how con-strained optimization problems can be solved using marginal reasoning.

Suppose a farmer plans to build a rectangular fence as apen for his sheep. He has F feet of fence and cannot af-ford to purchase more. However, he can choose the di-mensions of the pen, which will have a length of L feetand a width of W feet. He wants to choose the dimen-sions L and W that will maximize the area of the pen. Hemust also make sure that the total amount of fencing heuses (the perimeter of the pen) does not exceed F feet.

Problem

(a) What is the objective function for this problem?

(b) What is the constraint?

(c) Which of the variables in this model (L, W, and F )are exogenous? Which are endogenous? Explain.

Solution

(a) The objective function is the relationship that thefarmer is trying to maximizein this case, the area LW.

Constrained Optimization: The Farmers Fence

L E A R N I N G - B Y- D O I N G E X E R C I S E 1 . 1

In other words, the farmer will choose L and W to max-imize the objective function LW.

(b) The constraint will describe the restriction imposedon the farmer. We are told that the farmer has only F feet of fence available for the rectangular pen. Theconstraint will describe the restriction that the perime-ter of the pen 2L 2W must not exceed the amount offence available, F. Therefore, the constraint can be writtenas 2L 2W F.

(c) The farmer is given only F feet of fence to work with.Thus, the perimeter F is an exogenous variable, since itis taken as given in the analysis. The endogenous vari-ables are L and W, since their values can be chosen bythe farmer (determined within the model).

Similar Problems: 1.4, 1.16, 1.17

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8 CHAPTER 1 ANALYZING ECONOMIC PROBLEMS

Suppose a consumer purchases only two types of goods,food and clothing. The consumer has to decide how manyunits of each good to purchase each month. Let F be thenumber of units of food that she purchases each month,and C the number of units of clothing. She wants to max-imize her satisfaction with the two goods. Suppose theconsumers level of satisfaction when she purchases F unitsof food and C units of clothing is measured by the productFC, but she can purchase only limited amounts of goodsper month because she must live within her budget. Goodscost money, and the consumer has a limited income. Tokeep the example simple, suppose the consumer has a fixedmonthly income I, and she must not spend more than Iduring the month. Each unit of food costs PF and each unitof clothing costs PC.

Problem

(a) What is the objective function for this problem?

(b) What is the constraint?

(c) Which variables (PF, F, PC, C, and I ) are exogenous?Which are endogenous? Explain.

(d) Write a statement of the constrained optimizationproblem.

Solution

(a) The objective function is the relationship that the con-sumer seeks to maximize. In this example she will choosethe amount of food and clothing to maximize her satisfac-tion, measured by FC. Thus, the objective function is FC.

Constrained Optimization: Consumer Choice

L E A R N I N G - B Y- D O I N G E X E R C I S E 1 . 2

(b) The constraint represents the amounts of food andclothing that she may choose while living within her in-come. If she buys F units of food at a price of PF per unit,her total expenditure on food will be (PF)(F ). If she buysC units of clothing at a price of PC per unit, her total ex-penditure on clothing will be (PC)(C ). Therefore, hertotal expenditure will be (PF)(F ) (PC)(C ). Since hertotal expenditure must not exceed her total income I, theconstraint is (PF)(F ) (PC)(C ) I.

(c) The exogenous variables are the ones the consumertakes as given when she makes her purchasing deci-sions. Since her monthly income is fixed, I is exoge-nous. The prices of food PF and clothing PC are alsoexogenous, since she cannot control these prices. Theconsumers only choices are the amounts of food andclothing to buy; hence, F and C are the endogenousvariables.

(d) The statement of the constrained optimization prob-lem is

max FC(F,C)

subject to: (PF)(F ) (PC)(C ) I

The first line shows that the consumer wants to maximizeFC and that she can choose F and C. The second line de-scribes the constraint: total expenditure cannot exceedtotal income.

Similar Problems: 1.4, 1.16, 1.17

The constrained optimization problem for a powercompany can be complex:

The company needs to generate enough powerto ensure that its customers receive service dur-ing each hour of the day.

To make good production decisions, the com-pany must forecast the demand for electricity.

Examples of constrained optimization are all aroundus. Electric power companies typically own and oper-ate plants that produce electricity. A company mustdecide how much electricity to produce at each plantto meet the needs of its customers.

A P P L I C A T I O N 1.1

Generating Electricity: 8,760 Decisionsper Year

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7For a good discussion of the structure of electricity markets, see P. Joskow and R. Schmalensee, Marketsfor Power: An Analysis of Electric Utility Deregulation (Cambridge, MA: MIT Press, 1983).

only a short time (e.g., a few hours), it might notwant to shut down a plant that will be neededagain when the demand goes up.

The company must also take into account thecosts of transmitting power from the generatorsto its customers.

There is a spot market for electricity during eachhour of the day. A company may buy or sellpower from other electric power companies. Ifthe company can purchase electricity at a lowenough price, it may be able to lower the costs ofservice by buying some electricity from otherproducers, instead of generating all of the re-quired electricity itself. If it can sell electricity ata high enough price, the company may find itprofitable to generate more electricity than itscustomers need. It can then sell the extra electric-ity to other power companies.

Electric power companies typically make productiondecisions on an hourly basisthats 8,760 (365 daystimes 24 hours per day) production decisions a year!7

The demand for electricity varies from one hourto another during the day, as well as across sea-sons of the year. For example, in the summer thehighest demand may occur in the afternoon whencustomers use air conditioners to cool offices andhomes. The demand for power may declineconsiderably in the evening as the temperaturefalls.

Some of the companys plants are relatively ex-pensive to operate. For example, it is more ex-pensive to produce electricity by burning oil thanby burning natural gas. Plants using nuclear fuelare even less costly to run. If the company wantsto produce power at the lowest possible cost, itsobjective function must take these cost differencesinto account.

If the company expects the demand for electricityto be low for a long period of time, it may wantto shut down production at some of its plants.But there are substantial costs to starting up andshutting down plants. Thus, if the company ex-pects the demand for electricity to be low for

1.2 THREE KEY ANALYTICAL TOOLS 9

Imagine that you are the product manager for a small beer company that pro-duces a high-quality microbrewed ale. You have a $1 million media advertisingbudget for the next year, and you have to allocate it between local television andradio spots. Although radio spots are cheaper, television spots reach a far wider au-dience. Television spots are also more persuasive and thus on average stimulatemore new sales.

To understand the impact of a given amount of money spent on radio and TV ad-vertisements, you have studied the market. Your research findings, presented in Table 1.1,estimate the new sales of your beer when a given amount of money is spent on TV ad-vertising and on radio advertising. For example, if you spent $1 million on TV adver-tising, you would generate 25,000 barrels of new beer sales per year. By contrast, if youspent $1 million on radio advertising, you would generate 5,000 barrels of new salesper year. Of course, you could also split your advertising budget between the twomedia, and Table 1.1 tells you the impact of that decision, too. For example, if youspent $400,000 on TV and $600,000 on radio, you would generate 16,000 barrels ofnew sales from the TV ads and 4,200 barrels in new sales from the radio ads, for a totalof 16,000 4,200 20,200 barrels of beer overall.

In light of the information in Table 1.1, how would you allocate your advertisingbudget if your objective is to maximize the new sales of beer?

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10 CHAPTER 1 ANALYZING ECONOMIC PROBLEMS

This is a constrained optimization problem. You want to allocate spending onTV and radio in a way that maximizes an objective (new sales of beer) subject to theconstraint that the total amount spent on TV and radio must not exceed your $1 million advertising budget. Using notation similar to that introduced in the pre-vious section, if B(T, R) represents the amount of new beer sales when you spend T dollars on television advertising and R dollars on radio advertising, your con-strained optimization problem is

max B(T, R)(T,R)

subject to: T R 1 million

A quick reading of Table 1.1 might suggest an obvious answer to this problem:Allocate your entire $1 million budget to TV spots and spend nothing on radio. Afterall, as Table 1.1 suggests, a given amount of money spent on TV always generatesmore new sales than the same amount of money spent on radio advertising. (In fact,a given amount of TV advertising is five times as productive in generating new salesas is the same amount of radio advertising.) However, this answer is incorrect. And thereason that it is incorrect illustrates the power and importance of constrained opti-mization analysis in economics.

Suppose you contemplate spending your entire budget on TV ads. Under thatplan, you would expect to get 25,000 barrels of new sales. But consider now whatwould happen if you spent only $900,000 on TV ads and $100,000 on radio ads. FromTable 1.1, we see that your TV ads would then generate 24,750 barrels of new beersales, and your radio ads would generate 950 barrels of new beer sales. Thus, underthis plan your $1 million budget generates new beer sales equal to 25,700 barrels. Thisis 700 barrels higher than before. In fact, you can do even better. By spending$800,000 on TV and $200,000 on radio, you can generate 25,800 barrels of new beersales. Even though Table 1.1 seems to imply that radio ads are far less powerful than

TABLE 1.1 New Beer Sales Resulting from Amounts Spent on TV andRadio Advertising

New Beer Sales Generated(in barrels per year)

Total Spent TV Radio

$ 0 0 0$ 100,000 4,750 950$ 200,000 9,000 1,800$ 300,000 12,750 2,550$ 400,000 16,000 3,200$ 500,000 18,750 3,750$ 600,000 21,000 4,200$ 700,000 22,750 4,550$ 800,000 24,000 4,800$ 900,000 24,750 4,950$1,000,000 25,000 5,000

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1.2 THREE KEY ANALYTICAL TOOLS 11

TV ads, it makes sense in light of your objective to split your budget between radioand TV advertising.

This example highlights a theme that comes up repeatedly in microeconomics:The solution to any constrained optimization problem depends on the marginal im-pact of the decision variables on the value of the objective function. The marginal im-p